Capital Controls
The exchange rate effects

Capital controls are often imposed in response to balance-of- payments difficulties and exchange rate crises, yet their effect on the exchange rate is complicated. Capital controls affect decisions whether to consume today or save for tomorrow: that is, they are interventions in intertemporal trade. The real exchange rate, however, is an intratemporal price: the relative price of the home and foreign currencies today. The effect of capital controls therefore hinges on the interaction of intertemporal and intratemporal trade. In Discussion Paper No. 89, Research Fellow Sweder van Wijnbergen demonstrates that international asymmetries in expenditure patterns are the sole determinants of the real exchange rate effects of capital controls.

A tax on capital imports lowers world interest rates but raises home interest rates. As a consequence, the composition of world expenditure changes, although in aggregate it must necessarily remain equal to the level of world output. Higher real interest rates at home and lower real rates abroad imply a shift of home expenditure from today to tomorrow and a shift of foreign expenditure from tomorrow to today. A capital import tax will therefore change the composition of today's world expenditure, with less home and more foreign expenditure.

If the pattern of expenditure across commodities is identical at home and abroad, this change in composition has no effect on the demand for any particular commodity, so capital controls will have no effect on the real exchange rate. However, when domestic consumers have a preference for home-produced goods, there is a shift in the composition of world expenditure today away from home-produced goods. In that case, capital controls lower the real exchange rate in the current period. In the next period, when demand for home-produced goods increases, the reverse will happen.

Van Wijnbergen finds that this effect is mitigated when the country imposing capital controls is a large debtor. Capital controls, because they reduce world real interest rates, benefit countries which are large debtors. This 'income effect', arising from the transfer of income from creditors to the debtor country imposing the controls, will offset the shift in world expenditure caused by the 'relative price effects' of the interest rate changes. This will reduce the real exchange rate effects of the capital controls.


Capital Controls and the Real Exchange Rate
Sweder van Wijnbergen

Discussion Paper No. 89, December 1985 (IT)